One of America's great accomplishments in the last half-century was the so-called "democratization" of the financial markets. No longer just for the upper crust, investing became a way for the burgeoning middle class to accumulate wealth. Mutual funds exploded in size and number, 401(k) plans made savings and investing easy, and the excitement of participating in the growth of our economy gripped an ever larger percentage of the population. Despite a backdrop of doubters—those who knowingly asserted that outperforming the average was an impossibility for the small investor—there was a growing consensus that the rules were sufficient to protect the mom-and-pop investor from the sharks that swam in the water.
That sense of fair play in the market has been virtually destroyed by the bubble burstings and market drops of the past few years. Recent rebounds notwithstanding, most people now are asking whether the system is fundamentally rigged. It's not just that they have an understandable aversion to losing their life savings when the market crashes; it's that each of the scandals and crises has a common pattern: The small investor was taken advantage of by the piranhas that hide in the rapidly moving currents. And underlying this pattern is a simple theme: conflicts of interest that violated the duty the market players had to their supposed clients. It is no wonder that cynicism and anger have replaced what had been the joy of participation in the capital markets. Take a quick run through a few of the scandals:
- Analysts at major investment banks promote stocks they know to be worthless, misleading the investors who rely on their advice yet helping their investment-banking colleagues generate fees and woo clients.
- Ratings agencies slap AAA ratings on debt they know to be dicey in order to appease the issuers—who happen to pay the fees of the agencies, violating the rating agency's duty to provide the marketplace with honest evaluations.
- Executives receive outsized and grotesque compensation packages—the result of the perverted recommendations of compensation consultants whose other business depends upon the goodwill of the very CEOs whose pay they are opining upon, thus violating the consultants' duty to the shareholders of the companies for whom they are supposedly working.
- Mutual funds charge exorbitant fees that investors have to absorb—fees that dramatically reduce any possibility of outperforming the market and that are set by captive boards of captive management companies, not one of which has been replaced for inadequate performance, violating their duty to guard the interests of the fund investors for whom they supposedly work.
- "High-speed trading" produces not only the reality of a two-tiered market but also the probability of front-running—that is, illegally trading on information not yet widely known—that eats into the possible profits of the retail clients supposedly being served by these very same market players, violating the obligation of the banks to get their clients "best execution" without stepping between their customers and the best available price.
- AIG is bailed out, costing taxpayers tens of billions of dollars, even though (as we later learned) the big guys knew that AIG was going down and were able to hedge and cover their positions. Smaller investors are left holding the stock, and all of us are left picking up the tab.
The unifying theme is apparent: Access to information and advice, the very lifeblood of a level playing field, is not where it needs to be. The small investor still doesn't have a fair shot. While there have been case-specific remedies, the aggregate effect of all the scandals is still to deny the market the most essential of ingredients: the presumption of integrity.
The issue confronting those who wish to solve this problem is that there really is no simple fix. As easy as it is to excoriate those who violate their solemn duty to a client or the entity to which they owe a fiduciary duty, the remedies attempted over time have all had their own unintended consequences. Still, some conclusions can be reached: The scale and complexity of organizations—such as the investment banks that were to provide all services to all people—make the blurring of fiduciary duty inevitable. The difficulty of establishing a revenue stream for "content"—whether an analyst's report or a newspaper article—forces creative minds to pair that content with other revenue streams (such as investment banking fees) that generate conflicts. And the lack of disclosure of overlapping roles—whether for compensation consultants, members of boards of mutual funds, or high-speed traders who buy and sell both on the bank's account and for the bank's clients—make fiduciary duty tough to evaluate.
It is not clear that the new regulatory framework proposed by the Obama administration will directly improve the ability of regulators to address these tensions and conflicts. But if, indeed, there is a new consumer-protection agency created, it might want to set out as its first mandate the simple objective that it get every market participant to define clearly (and publicly) to whom it owes a fiduciary duty—and what possible tensions might exist in fulfilling that duty. If this agency does nothing more than root out those conflicts and examine them, it would be providing the small American investor with a valuable service, one that the SEC and others have failed to perform over the past decade.
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